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2 CONTENTS OVERVIEW AND DEFINITION 1 HISTORY 2 TYPES OF SECURITIES LENDING 3 Transactions Collateralised with Securities 3 Transactions Collateralised with Cash 3 The Role of Intermediaries PROFITING FROM STOCK LENDING 4 Fees 4 Facilitating Settlement 4 Short Selling 5 Dividend Arbitrage IMPLICATIONS FOR PLCs 6 Growth of Stock Lending 6 Share Register Analysis 7 Corporate Governance «=j~âáåëçå=`çïéää=ommr

3 OVERVIEW AND DEFINITION OVERVIEW Stock lending is an increasing focus of attention in the UK. CrestCo began to publish data on the activity in September 2003; analysis of that data reveals both that stock lending is growing, and more dramatically that in some circumstances a very high percentage of a company s shares can be out on loan. Companies are rightly concerned, because stock lending makes it less clear who really controls them; those worried about corporate governance are concerned too, because the practice complicates the exercise of owners responsibilities. This paper looks at the history of securities lending, the different guises it takes and the mechanisms it utilises. It looks at the role securities lending plays in the smooth running of financial markets. Furthermore, it examines the economic benefits of securities lending to both the lender and the borrower, and its implications for quoted companies. While a number of possible reforms are being discussed, there are good economic reasons why stock lending will not go away. On the contrary, to the extent that more hedge funds and other investors use short selling as one of their investment tactics, lending is likely to increase. However, good investor relations practice, and in particular careful analysis of developments on the share register, should be able to eliminate much of the concern that may otherwise arise. DEFINITION Securities lending describes the market practice by which, for a fee, securities are transferred temporarily from one party, the lender, to another, the borrower; the bor- rower is obliged to return the securities either on demand or at the end of an agreed term. Lenders want to lend because it earns them a fee from otherwise idle assets. Borrowers want to borrow for three broad sets of reasons - to ensure that transactions settle which otherwise would fail; because a security is temporarily of more value to them than to the lender (e.g. because they are in a different tax position); or because they want to sell short a security that they do not own. In law the transaction is in fact an absolute transfer of title (sale) against an undertaking to return equivalent securities. The borrower in return collateralises the transaction with cash or other securities of greater or equal value than the lent securities. The term lending in this context is therefore somewhat of a misnomer, with the transaction more characteristic of a sale-and-repurchase than a loan. The most important consequences of stock lending arise from this absolute transfer of title: i. Absolute title over both lent and collateral securities passes between the parties, therefore these securities can be sold outright and on lent. Both practices are commonplace and an intrinsic part of the functioning of the market. ii. A lender is still exposed to price movements on lent securities since the borrower is committed to returning them. The borrower is entitled to the other economic benefits of owning the lent securities (e.g. dividends) but the agreement with the lender will oblige them to make equivalent ( manufactured ) payments back to the 1

4 HISTORY lender. iii. A lender of equities no longer owns them and voting rights are passed to the borrower. Although lenders will usually reserve the right to recall securities, thereby giving them the opportunity to vote if they wish, this right is seldom utilised. There is, however, a consensus in the market that securities should not be borrowed solely for the purpose of exercising the voting rights (Securities Borrowing and Lending Code of Guidance, Bank of England Securities Lending and Repo Committee, December 2004). At British Land s 2002 AGM, Laxey Partners tabled a motion to unseat the Chairman, and voted their 9% holding. The institution was unsuccessful but, more importantly, it transpired that Laxey owned only 1% of British Land and had borrowed 8% for the purpose of voting. Laxey had done nothing illegal but their actions resulted in an investigation by the Department of Trade and Industry and embarrassed both the lending institutions and Laxey. Such is the importance of this issue, the Takeover Panel is currently reviewing its thoughts on the disclosure of holdings in takeover targets. Lending is not currently considered the same as dealing by the panel, and as such the same rules on disclosure do not apply. However, given that lenders do not invariably recall stock before critical events this may have to be rethought. A paper concerning this issue is expected shortly. HISTORY Although securities lending has become a complicated beast, it began and it continues to exist today because there is a supply and demand for its services. In the 17th Century, trading by the Dutch East India Company between Amsterdam and London facilitated an early form of arbitrage. The fastest ships would sail from London to Amsterdam carrying news of the day s trading, with Dutch traders subsequently using the information to go short of certain goods; a process that required the borrowing of goods. Then, as now, securities lending was about putting otherwise idle assets to work. Modern securities lending developed handin-hand with the securities trading markets. During the 1960s an increase in trading volume, combined with a paper-based settlement system, led to a large backlog of trades outstanding and back offices borrowing securities to cover settlements. Throughout the 1970s settlement related demand reduced but demand from specialist borrowers increased, particularly from arbitrageurs. Increase in demand continued throughout the 1980s with cross border lending becoming more prevalent, and a wider variety of trading strategies reliant on borrowing securities appearing in the market. Demand grew further in the 1990s with the rapid growth in hedge fund assets under management, and with the removal of many regulatory, tax and structural barriers to securities lending throughout the world. In the 21st Century securities lending has continued to develop. The market now includes third party lending agents, prime brokers, and new instruments, such as contracts for differences (CFDs). With a CFD the purchaser receives the economic benefits of the underlying equity without the need physically to trade in the underlying stock, thereby avoiding stamp duty and enabling the purchaser to trade on margin. 2

5 TYPES OF SECURITIES LENDING The availability of CFDs encourages more investors to engage in short selling and thus leads to more stock lending as market makers borrow securities to hedge the CFDs they have written. Furthermore, continuing deregulation and tax changes in emerging markets have widened the stock lending market. TYPES OF SECURITIES LENDING Most securities loans are collateralised, either with other securities or with cash deposits. TRANSACTIONs COLLATERALISED WITH SECURITIES Where lenders take securities as collateral they are paid a fee by the borrower. A wide range of securities are likely to be accepted by the lender, including government bonds, corporate bonds, convertible bonds and equities. A lender will require that the value of this collateral incorporates a margin, usually 5%, in order to cover market fluctuations in the value of lent securities and collateral received. Borrowers will therefore supply collateral with a value of 105% of the lent securities. TRANSACTIONS COLLATERALISED WITH CASH Although transactions collateralised with cash are less common in European markets than those collateralised with securities, they are increasing in popularity and are already much more prevalent in the US. Where lenders are given cash as collateral they pay the borrower interest at a specified rate, known as the rebate rate. The lender will in turn invest the collateral at market rates. The fee the borrower pays therefore is the difference between the risk free rate and the rebate rate. In return, the borrower receives both the lent securities and a relatively risk free return on the collateralised cash (at a level lower than market rates). THE ROLE OF INTERMEDIARIES The securities lending market involves various types of specialist intermediary who link the underlying owners of securities (beneficial owners and custodians) with the eventual borrowers. These intermediaries will take either agency and/or principal roles. Stock lending is increasingly becoming a volume business and the advantages of scale offered by agents that pool together the securities of different clients enable smaller owners of assets to participate in the market. Although some asset managers have begun offering stock lending services, the largest agents are custodian banks. Custodian banks are able to mobilise large pools of funds and have the advantages of size, existing relationships with customers, experience, and the ability to manage cash collateral efficiently. In contrast, principal intermediaries can assume principal risk, offer credit intermediation and take positions in the securities that they borrow. Intermediaries of this kind can take several forms but most well known are those that serve the needs of hedge funds, otherwise known as prime brokers. A demand exists for principal intermediaries because beneficial owners are reluctant to expose themselves to borrowers that are not well recognised, regulated, or have a poor credit rating - these categories include most hedge funds, who are important potential borrowers. In these circumstances, the principal intermediary will borrow stock from institutions on call (giving lenders the opportunity to recall the stock at any time) whilst lending to clients on term (stock cannot be recalled early, ensuring that a borrower can cover short positions). The intermediary there- 3

6 PROFITING FROM STOCK LENDING fore leaves itself open to significant liquidity risk. PROFITING FROM STOCK LENDING As we have seen, lenders are able to profit from otherwise idle assets, whether they are collateralised with securities or cash. Furthermore, they can include stock lending returns in the value of a fund, thereby boosting performance. The factors influencing the level of stock lending fees include the demand for a particular security, the size of the manufactured dividend required to compensate the lender, and the likelihood that a borrower will make an early recall of the stock. Stock lending fees can be as low as 5 basis points per annum (of the total value of the loan), or as high as 400 basis points or even more in extreme circumstances. The great majority of transactions are at the lower end of this range. The current average in the UK equity market is about 14 basis points. Small cap stocks will usually demand the highest fees whilst FTSE100 stocks can be borrowed for smaller sums. Fees tend to be higher in other European markets, averaging perhaps 40 basis points. There are a number of reasons why borrowers are prepared to pay these fees: FACILITATING SETTLEMENT Securities lending promotes market stability and liquidity by allowing market makers to borrow securities for settlement purposes. Market makers stand ready to make markets in a particular security, irrespective of the availability of the shares. Inevitably they will sometimes be unable to settle a bargain, and will make up the temporary short fall by borrowing the shares from institutions. The securities lending system thus promotes market stability by helping limit the share price changes that could result from stock shortages. SHORT SELLING As noted previously, there is nothing new about the idea of people trying to profit by selling securities that they do not own and that they believe are overpriced. In recent years, the dramatic growth of the hedge fund industry in the UK and elsewhere has led to a significant increase in the incidence of stock lending. Hedge funds and others sell borrowed stock in the expectation that when the time comes to return the loan, the price of the stock will have dropped. They can then buy back the required amount of stock in the market at a lower price than they sold it for and profit from the difference. Such shorting will usually form part of a larger trading strategy, typically designed to profit from perceived pricing discrepancies between related securities. For example, through a strategy known as pairs trading, hedge funds seek to identify two companies, usually within the same sector, whose equity securities are trading out of line with the historical price relationship. The apparently undervalued security is bought, while the apparently overvalued security is sold short. Alternatively, short selling may be driven by corporate activity, or by new information about underlying value. An example of the former is merger arbitrage, where an arbitrage opportunity may exist by owning shares in the bid target but going short of the bidder s stock. 4

7 PROFITING FROM STOCK LENDING DIVIDEND ARBITRAGE CASH DIVIDEND Another class of transaction reliant on stock lending is dividend arbitrage, a strategy that takes advantage of the differential tax treatment of different investors. For example, French tax rules provide French investors with a 10% tax credit on dividend income that is not available to UK shareholders. Therefore a number of institutions, led by French banks such as BNP Paribas and Credit Lyonnais, enter into agreements to borrow UK equities ahead of the dividend record date in order to receive the dividend payment. As the borrower can derive a greater net dividend return from the equity than the lender, the former can compensate the latter for the lost dividend and still profit. Heightened stock lending activity during these periods can be very significant. Across Makinson Cowell s FTSE100 clients, stock lending levels regularly rise to 10% and above around a dividend record date, as compared to a yearly average of c.5%. SCRIP DIVIDEND A related source of borrowing is scrip dividend arbitrage. An issuer offers shareholders the choice of receiving a cash dividend or a scrip dividend at a discount to the market price, the latter often being seen as the more attractive option. However, some funds (e.g. index trackers) are unwilling to take the scrip alternative because their holdings would become larger than their investment guidelines permit. In such instances, stock can be lent out with the borrower choosing the scrip and selling the newly issued shares in the market. The proceeds from selling the scrip shares are used to pay the lender the cash dividend they have forgone by lending the shares. The borrower makes a profit equal to the difference between the market value of the shares and the cash dividend, less the stock lending fee. 25% 20% 15% Example of Scrip Dividend Arbitrage: Prudential Dividend record date Dividend record date Dividend record date 15% 12% Example of Cash Dividend Arbitrage: BAE Systems Dividend record date Dividend record date 10% 5% 9% 0% J F M A M J J A S O N D J F M A % Prudential Source: CrestCo FTSE 100 3% 0% J F M A M J J A S O N D J F M A BAE Systems Source: CrestCo FTSE 100 As the graph above shows, some of the largest stock lending movements in a company s share register arise from cash dividend arbitrage transactions. In contrast to cash dividend arbitrage, where the stock has been borrowed to take advantage of a scrip dividend, the lending period is much shorter (as shown above). This reflects the length of time an equity must be held for to be eligible for a scrip. 5

8 IMPLICATIONS FOR PLCs IMPLICATIONS FOR PLCs As shown below, over the last 18 months the average percentage of shares on loan in the London market has increased. 6% 5% 4% 3% 2% 1% 0% S O N D J 2003 FTSE 100 Source: CrestCo Stock Lending: 9/03-4/05 F M A M J J A S O N D J F M A FTSE 250 From 3.5% in September 2003, the FTSE100 average is now a little over 5% while the FTSE250 average has moved up from 2% to 3%. Analysis by Spitalfields Advisors (Balancing fiduciary responsibility of proxy voting with securities lending, 24 February 2005), a leading securities lending consultancy firm, suggests that there is currently an estimated c. 400 billion of equities available for loan in the UK market, approximately 30% of the total UK equity market. The extent to which this capacity is utilised fluctuates but averages perhaps 10%, i.e. c. 40 billion. Regardless of the reasons why stock is lent, it results in a physical transfer of shares on a share register. There is no distinction on a register between movements due to stock lending and those resulting from true trading. Therefore, when an institution lends stock, its holding in a company will appear to fall. This is indeed accurate in the short term, the absolute title of the shares has been passed to the borrower; however, in the longer term, the institution s holding will return to its original level when the loan is returned. Confusion occurs because stock lending is reflected on a share register as the buying and selling of stock, but this is not the reality of the situation. Makinson Cowell s specialist share register analysis team regularly identifies instances of stock lending. The most prominent lenders of stock are usually long-term investors, such as AXA Investment Managers, Barclays Global Investors, F&C Asset Management, Hermes Pensions Management, Insight Investment, M&G, Morley Fund Management, Scottish Widows Investment Partnership and State Street Global Advisors. These institutions are able to enhance their portfolio performance by lending out stock. What is the destination of the lent shares? In some instances stock will be lent out by a long-only investor, perhaps to a hedge fund, who will in turn sell on these shares to a second long-only investor. In this case, the decrease in one investor holding on the register will be compensated by the increase in that of another. If this is not the case - and increasingly it is not - the stock will be picked up by market makers. The market maker either holds the stock on its own account, or more likely will hold it as a hedge against a CFD position that it has written with a hedge fund or other investor. In either case the stock will appear under the Market Participants heading in a register analysed by Makinson Cowell. As such, the amount of stock directly cracked to long term investors will diminish. When stock lending is accompanied by higher levels of CFD trading, the share register becomes even more opaque. As market makers write CFD trades and hedge their exposure by buying and selling the underlying stock, 6

9 IMPLICATIONS FOR PLCs the net result is often an even higher level of market participant holding. Recent reports by the International Corporate Governance Network (ICGN; Share lending vis-à-vis voting, 28 May 2004), and by Paul Myners (Review of the impediments to voting UK shares, 3 February 2004 & 14 March 2005), have highlighted issues regarding the recall of stock for the purpose of voting. The majority of participants in the ICGN survey who lent stock stated that although they would normally vote shares, they would not specifically recall shares out on loan in order to do so. Fund managers therefore face a trade-off between forgoing the return on stock lending and casting a vote, with a reluctance to accept the former usually taking precedence. kept in line, Myners believes that all lenders should have a policy of recalling stock if a resolution is contentious. Furthermore, those issuing voting instructions should seek to anticipate contentious votes and recommend to shareholders that the related stock is not lent. This problem may also be compounded by the practice of dividend arbitrage. As AGMs often fall part way through the timetable for benefiting from arbitrage of the final dividend payment, the level of stock lending during the period in which shares may be voted is likely to be much higher than during the rest of the year. This stock will seldom be recalled for voting, and is unlikely to be voted by the borrowing party, as such companies may wish to consider the timetabling of dividends with this in mind. Paul Myners believes that lenders may also need to be more vigilant. In an initial report published in February 2004 and followed up by a progress report in March 2005, Myners suggests that lenders must be cautious about when and to whom they lend stock. In order to ensure that shares are not borrowed with the purpose of influencing a vote, and that the economic and political ownership of a company is 7

10 STOCK LENDING - A PERSPECTIVE Please contact Colin Watts for further information on stock lending and its impact on companies. Colin Watts is the company secretary and compliance officer of Makinson Cowell. He also has responsibility for the company s shareholder identification and analysis work.(colinwatts@makinson-cowell.co.uk) Makinson Cowell Limited Cheapside House 138 Cheapside London EC2V 6LQ Tel: +44 (0) Fax: +44 (0) enquiries@makinson-cowell.co.uk Authorised and regulated by the Financial Services Authority 8